As reported at Reuters, hedge funds have been raising capital and are looking for ways to deploy it in the current market. Possible outlets include distressed debt and higher quality mortgage debt. Funds also hope to take advantage of lower stock prices as forced selling of equities is expected to intensify as the summer progresses. Famed hedge fund manager John Paulson, who made a correct (and profitable) bet on sub-prime last year, predicts more gains from distressed debt as he expects to see an additional $10 trillion opportunity develop over the next 6-24 months.

Changes in focus are already showing benefits. The Credit Suisse / Tremont index rose 2% in May, as long/short equity, event-driven, and emerging market funds outperformed. High volatility and widening credit spreads are also creating opportunities for convertible arbitrage funds. Of interest is that quants funds are also optimistic, with the optimism not necessarily due to the current market opportunities, but due more to less competition from other quant funds. Last year forced credit selling created unpredictable moves (both directional and magnitude) that ended up shaking out a number of less-capitalized funds that were unable to adapt quickly enough to changing market conditions. Whether the rest of 2008 is any more predictable is yet to be seen.

I often get asked about subprime, Colateralized Debt Obligations - CDO, Collageralized Mortgage Obligations - CMO, Credit Default Swaps - CDS, and that odd thing called a tranche by people other than my students - who already had to endue my lectures on the subject. Therefore, I figured it was worth putting together something for the blog, outside of what I normally teach. Hopefully I can find the time to develop and post a series of tutorials this summer, but in the mean time the following short segment from CNBC's PowerLunch is a good start regarding subprime and the creation of mortgage-backed derivatives (such as CMOs).

There are other explanations (videos and Powerpoints) that are more entertaining and a little less tasteful at times (and also sometimes better at explaining the subject), but I will take the high road for now and let you find those on your own. A few longer presentations that are more informative, but also a little dryer, also exist.

Thames River fund, the same fund that made a small fortune (actually a large fortune) shorting subprime last year has gone long a few subprime assets that have been hit hard over the last year. The call is less about the quality of subprime, and simply a valuation play - the assets have gotten cheap with prices that are low relative to their expected default rates. With a few subprime securities trading at 10 cents on the dollar, the risk/reward is appearing favorable, but picking a bottom is difficult. Cheap assets can always get cheaper. Even so, it encouraging that some of the same traders and funds that successfully sold the market down during last year's credit fallout are beginning to take the other side. The smart money tends to buy when things look the worst, or at least that is what we are led to believe. I am sure there is also a little selection bias here as with other trades and asset classes, as those incorrectly predicting market tops and bottoms get filtered out. Regardless (easy for us to say), at least we are hearing of major players with large capital going long, signaling a potential shift in market sentiment for this area of the credit markets - a signal that if true, even if early, has much larger ramifications.